valuing-a-business | KPMG | JM

Valuing a Business

KPMG Deal Advisory will be issuing a series of articles on the topic of business valuation and impairment testing – for this article we will focus on the three valuation methodologies.

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Valuation

How do you value a business? Answering this question is not a difficult one as long as the valuator asks the right questions.

There are two general approaches to the valuation of a business - the liquidation approach and the going concern approach. For this article, we will assume the subject business to be valued is a going concern (i.e. the business will continue operating into the foreseeable future).

Broadly any business can be valued under three valuation methodologies. The three methodologies being classified as asset-based methodologies, income-based methodologies or market-based. The methodology chosen by the valuator is the one that yields the higher value.

Asset-based valuation

Asset-based valuation determines the business value based on the value of its net assets without consideration of its future earnings capacity.

This approach also known as the adjusted net asset approach is appropriate in the valuation of:

  • An investment or real estate holding company (since value is closely related to the company’s underlying assets as opposed to its earnings capacity);
  • An operating business that does not generate sufficient earnings to realize a reasonable return on the net tangible assets, but whose value as a going concern is higher than the liquidation value; and
  • An operating business where all of the income is attributable to personal goodwill (i.e. goodwill that is not transferable to a purchaser).
     

Income based valuation

Income-based valuation determines the value of a business based on its ability to generate economic benefit for the owners. The discretionary cash flows are either capitalized or discounted to derive the value.

The most commonly adopted earnings/cash flow-based methods used are:

  •  Capitalization of maintainable net earnings;
  •  Capitalization of maintainable after-tax discretionary net cash flow; and
  • Discounting of discretionary cash flows.

Other valuation income based methods include the following:

  • Capitalization of maintainable earnings before interest and income taxes (EBIT), which is similar to the capitalization of indicated net earnings; and
  •  Capitalization of maintainable earnings before interest, income taxes, depreciation and amortization (EBIT-DA), which is similar to the capitalization of indicated after-tax discretionary net cash flow.
     

Market-based valuation

Market-based valuation considers public equity market data and recent transactions for similar businesses to determine multiples or other financial ratios that can then be used in conjunction with the earnings/cash flow-based or asset-based approaches to support value conclusions. This type of analysis includes:

  • A comparable company analysis; and
  •  A comparable transaction analysis.

A comparable company analysis involves a review of the public equity market (i.e., stock exchange trading prices and underlying financial data of the publicly traded comparable companies) with a view to determining implied ratios and multiples for a public company to apply to the valuation of the subject private company

A comparable transaction analysis involves a review of recent transactions of similar companies to provide indicators of rates of returns required by investors. This method is very similar to the public company multiples approach, except that instead of looking at public companies trading on a stock market, valuation multiples are developed by reviewing and analyzing companies that have recently been bought or sold in the marketplace.

This article has looked valuation methods spoke about value in the generic sense. The next article will look at the topic of value and how it is defined and the differences and similarities between fair market value, fair value under IFRS 13, replacement value, value to owner, etc.

Future articles will discuss the selection of appropriate discount rates, capitalization rates and how valuators address concerns over the reasonability of cash flows being provided by third parties.

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